(ACCT 3304) Chapter 9

Colicchio Corporation acquired two inventory items at a lump-sum cost of $60,000. The acquisition included 3,000 units of knife X001, and 3,000 units of knife X002. X001 normally sells for $20 per unit, and X002 for $10 per unit. If Colicchio sells 1,000 units of X002, what amount of gross profit should it recognize? Round percentages to 2 decimal places. (a) $1,000. (b) $3,330. (c) $6,670. (d) $10,000.

(b) $3,330. The sales value of X001 is (3,000 × $20 each) $60,000 and the X002 units are (3,000 × $10 each) $30,000 totaling $90,000. Thus, the cost allocated to X002 based on relative sales values is ($30,000/$90,000) 33.33% of the $60,000 or $20,000. The cost per unit of X002 is ($20,000/3,000) $6.67 making 1,000 units worth $6,670. Revenues of $10,000 less cost of $6,670 results in a gross profit of $3,330.

The replacement cost of an inventory item is $90. Net realizable value is $97.50. Net realizable value less a normal profit margin is $88.50. The cost of the item is $93. The designated market value used in applying Lower-of-LIFO-Cost-or-Market is... (a) $88.50. (b) $90. (c) $93. (d) $97.50.

(b) $90. The designated market value is the middle number of replacement cost ($90), net realizable value ($97.50) and net realizable value less a normal profit margin ($88.50).

When the cost of goods sold method is used adjust cost to "market", what account is used to record the income effect of valuing inventory at NRV? (a) Inventories. (b) Cost of Goods Sold. (c) Loss Due to Market Decline of Inventories. (d) Allowance to Reduce Inventory to Market Value.

(b) Cost of Goods Sold. When the cost of goods sold method is used, Cost of Goods Sold is debited and an allowance account is credited.

The percentage markup on cost can be computed by dividing gross profit by 100%: (a) plus gross profit. (b) minus gross profit. (c) plus markup on cost. (d) minus markup on cost.

(b) minus gross profit. Dividing gross profit by 100% minus gross profit yields the percentage markup on cost.

The replacement cost of a FIFO cost inventory item is $75. Net realizable value is $82.50. Net realizable value less a normal profit margin is $69. The cost of the item is $76.50. The inventory item would be valued at: (a) $69. (b) $75. (c) $76.50. (d) $82.50.

(c) $76.50. Lower-of-Cost-or-NRV is used since the cost flow assumption is FIFO. Cost is lower than NRV ($76.50 < $82.50), so the inventory is valued at the lower of the two amounts, $76.50.

High Country Corporation acquired two inventory items at a lump-sum cost of $80,000. The acquisition included 6,000 units of product A, and 14,000 units of product B. Product A normally sells for $12 per unit, and product B for $4 per unit. If High Country sells 2,000 units of A, what amount of gross profit should it recognize? (a) $750. (b) $2,250. (c) $9,000. (d) $4,750.

(c) $9,000. The sales value of A is (6,000 units × $12 each) $72,000 and the B is (14,000 units × $4 each) $56,000 totaling $128,000. Thus, the cost allocated to A based on relative sales values is ($72,000 / $128,000) 56.25% of the $80,000 or $45,000. The cost per unit of A is ($45,000/6,000) $7.50 resulting in a cost for 2,000 units of $15,000. Revenues of $24,000 less $15,000 results in a gross profit of $9,000.

The inventory turnover ratio is computed by dividing the cost of goods sold by... (a) beginning inventory. (b) ending inventory. (c) average inventory. (d) number of days in the year.

(c) average inventory. The inventory turnover ratio is computed by dividing the cost of goods sold by average inventory.

When using dollar-value LIFO, if the incremental layer was added last year, it should be multiplied by... (a) last year's cost ratio and this year's index. (b) this year's cost ratio and this year's index. (c) last year's cost ratio and last year's index. (d) this year's cost ratio and last year's index.

(c) last year's cost ratio and last year's index. Last year's cost ratio and last year's index would be used if the incremental layer was added last year.

Under the conventional retail inventory method, the cost-to-retail ratio includes the retail price of goods available and: (a) markups only. (b) markups and markdowns. (c) net markups only. (d) net markdowns only.

(c) net markups only. The cost-to-retail ratio includes net markups under the conventional retail method.

An estimated loss on purchase commitments is reported: (a) as a valuation account. (b) as an item similar to discontinued operations. (c) under Other Expenses and Losses. (d) as a deduction from purchases.

(c) under Other Expenses and Losses. An estimated loss on purchase commitments is reported under Other Expenses and Losses.

Viewpoint Company's October 31 inventory was destroyed by fire. The company's beginning inventory was $500,000, and purchases for January through October were $1,200,000. Sales for the same period were $1,800,000. The company's normal gross profit percentage is 30% of sales. Using the gross profit method, the October 31 inventory is estimated to be: (a) $40,000. (b) $540,000. (c) $300,000. (d) $440,000.

(d) $440,000. ($500,000 + $1,200,000) − [$1,800,000 − ($1,800,000 × .30)] = $440,000.

Which of the following statements about IFRS for inventory accounting is not true? (a) IFRS provide more limited guidance than GAAP for inventory accounting. (b) IFRS allows reversals of write-downs up to the amount of the previous write-down. (c) IFRS prohibits the use of LIFO. (d) IFRS defines market value as replacement cost subject to the constraints of a ceiling and floor.

(d) IFRS defines market value as replacement cost subject to the constraints of a ceiling and floor. IFRS defines market value as net realizable value without regard to the ceiling and floor constraints required by GAAP in some cases.

Which of the following is included in the calculation of the cost-to-retail ratio under the conventional retail inventory method? (a) Markdowns only. (b) Markdowns and markdown cancellations. (c) Markups only. (d) Markups and markup cancellations.

(d) Markups and markup cancellations. The conventional retail inventory method does not include markdowns or markdown cancellations in the calculation of the cost-to-retail ratio.

The primary basis of accounting for inventories is cost. A departure from the cost basis of pricing the inventory is required where there is evidence that when the goods are sold in the ordinary course of business their... (a) selling price will be less than their replacement cost. (b) replacement cost will be more than their net realizable value. (c) cost will be less than their replacement cost. (d) future utility will be less than their cost.

(d) future utility will be less than their cost. To preclude overstating assets, the lower of cost or market (future utility) is used for inventory valuation.

In applying Lower-of-LIFO-Cost-or-Market, the designated market value is... (a) the higher of replacement cost or net realizable value less a normal profit margin. (b) net realizable value less a normal profit margin. (c) the lower of net realizable value or replacement cost. (d) the middle value of replacement cost, net realizable value and net realizable value less a normal profit margin.

(d) the middle value of replacement cost, net realizable value and net realizable value less a normal profit margin. In applying Lower-of-Cost-or-Market, the designated market value is the middle value of replacement cost, net realizable value and net realizable value less a normal profit margin.

Retail Inventory Method

A method used by retailers, to value inventory without a physical count, by converting retail prices to cost. For high volume retailers (e.g. Target), determining cost of each sale and allocating transportation costs to each shipment of inventory is costly. These retailers compile the inventories at retail prices and use the cost and price pattern to figure out and convert retail price to cost. Assumption: The cost and price pattern is stable. You must keep the following information: Cost and retail value of beginning inventory, cost and retail value of purchases, and sales for the period. Note: Unlike the gross profit method, the retail value is needed. Methods: Conventional, Cost, LIFO Retail, and Dollar-Value LIFO. Steps to Computation: 1. BI (cost) + Purchase (cost) - Sales (CGS) = EI (cost) 2. BI (retail) + Purchase (retail) - Sales (retail) = EI (retail) 3. Once we compute EI (retail) with given information, we can compute EI (cost) using the relation between cost & retail.

Valuation Using Relative Sales Value

A special problem arises when a company buys a group of varying units in a single lump-sum purchase, also called a basket purchase. Allocate the total cost to the individual items using their relative sales value.

The Gross Profit Method of Estimating Inventory

Companies take a physical inventory to verify the accuracy of the perpetual inventory records or, if no records exist, to arrive at an inventory amount. Sometimes, however, taking a physical inventory is impractical. In such cases, companies use substitute measures to approximate inventory on hand. One substitute method of verifying or determining the inventory amount is the gross profit method (also called the gross margin method). Auditors widely use this method in situations where they need only an estimate of the company's inventory (e.g., interim reports). Companies also use this method when fire or other catastrophe destroys either inventory or inventory records. The gross profit method relies on three assumptions: 1. The beginning inventory plus purchases equal total goods to be accounted for. 2. Goods not sold must be on hand. 3. The sales, reduced to cost, deducted from the sum of the opening inventory plus purchases, equal ending inventory.

Ceiling

The ceiling is equal to net realizable value (estimated selling price less estimated disposal cost). Why? To prevent overstatement of inventories and understatement of the loss in the current period.

Floor

The floor is equal to the ceiling less normal profit margin. Why? To prevent understatement of inventories and overstatement of the loss in the current period.

Computation of Gross Profit Percentage

The terms "gross margin," "gross profit," and "markup" are synonymous. There is a distinction though between markup expressed as a percentage of cost and markup expressed as a percentage of sales. In most situations, the gross profit percentage is stated as a percentage of selling price.

Average Days to Sell Inventory

This measure represents the average number of days' sales for which a company has inventory on hand. Average Days to Sell Inventory = 365/Inventory Turnover

Which of the following statements are correct when a company applying the lower of cost or market method reports its inventory at replacement cost? I. The original cost is less than replacement cost. II. The net realizable value is greater than replacement cost. a. Neither I nor II. b. I only. c. II only. d. Both I and II.

c. II only.

In no case can "market" in the lower-of-cost-or-market rule be more than... a. estimated selling price in the ordinary course of business. b. estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal and an allowance for an approximately normal profit margin. c. estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal. d. estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal, an allowance for an approximately normal profit margin, and an adequate reserve for possible future losses.

c. estimated selling price in the ordinary course of business less reasonably predictable costs of completion and disposal.

Based on a physical inventory taken on December 31, 2017, Chewy Co. determined its chocolate inventory on a FIFO basis at $26,000 with a replacement cost of $20,000. Chewy estimated that, after further processing costs of $12,000, the chocolate could be sold as finished candy bars for $40,000. Chewy's normal profit margin is 10% of sales. Under the lower of cost or market rule, what amount should Chewy report as chocolate inventory in its December 31, 2017, balance sheet? a. $28,000. b. $20,000. c. $26,000. d. $24,000.

d. $24,000.

Which one of the following is deducted in computing the cost-to-retail ratio? (a) Abnormal shortages. (b) Sales returns. (c) Normal shortages. (d) Employee discounts.

(a) Abnormal shortages. Abnormal shortages are the only option deducted in computing the cost-to-retail ratio.

Which of the following is not permitted under IFRS? (a) reporting of any type of inventory at net realizable value. (b) lower-of-cost-or-NRV valuation. (c) reversals of lower-of-cost-or-NRV write-downs. (d) the use of the LIFO cost flow assumption.

(d) the use of the LIFO cost flow assumption. IFRS prohibits the use of LIFO.

Why Retail Inventory Method if Used?

1) To permit the computation of net income without a physical count of inventory. 2) Control measure in determining inventory shortages. 3) Insurance information.

The Cost Retail Method (Assumption B)

Calculates the cost to retail ratio including both net markups and net markdowns. It approximates the original cost of inventory without considering the loss of inventory value. But there may be a case, you really want to know the original cost not LCM.

Use of an Allowance - Multiple Periods

In general, accountants leave the allowance account on the books. They merely adjust the balance at the next year-end to agree with the discrepancy between cost and the LCNRV at that balance sheet date. Thus, if prices are falling, the company records an additional write-down. If prices are rising, the company records an increase in income.

Use of an Allowance

Instead of crediting the Inventory account for market adjustments, companies generally use an allowance account, often referred to as Allowance to Reduce Inventory to NRV. Use of the allowance account results in reporting both the cost and the NRV of the inventory.

Lower-of-Cost-or-Net Realizable Value (LCNRV)

Inventories are recorded at their cost. However, if inventory declines in value below its original cost, a major departure from the historical cost principle occurs. Whatever the reason for a decline—damage, physical deterioration, obsolescence, changes in price levels, or other causes—a company should write down the inventory to net realizable value to report this loss. A company abandons the historical cost principle when the future utility (revenue-producing ability) of the asset drops below its original cost.

Purchase Commitments

It is quite common for a company to make purchase commitments, which are agreements to buy inventory weeks, months, or even years in advance. Usually, it is not necessary for the buyer to make any entries to reflect commitments for purchases of goods that the seller has not shipped. Ordinary orders, for which the buyer and seller will determine prices at the time of shipment and which are subject to cancellation, do not represent either an asset or a liability to the buyer. Therefore, the buyer need not record such purchase commitments or report them in the financial statements. What happens, though, if a buyer enters into a formal, noncancelable purchase contract? Even then, the buyer recognizes no asset or liability at the date of inception, because the contract is "executory" in nature: Neither party has fulfilled its part of the contract. However, if material, the buyer should disclose such contract details in a note to its financial statements. If the contract price is greater than the market price and the buyer expects that losses will occur when the purchase is effected, the buyer should recognize losses in the period during which such declines in market prices take place.

Retail Terminology

Markups: Increases in prices. Markdowns: Decreases in prices. Markup cancellation: When a markup is cancelled. Markdown cancellation: When a markdown is cancelled. Net Markup: Markup - markup cancellation. Net Markdown: Markdown - markdown cancellation.

Inventory Turnover

Measures the number of times on average a company sells the inventory during the period. It measures the liquidity of the inventory. To compute inventory turnover, divide the cost of goods sold by the average inventory on hand during the period.

Recording NRV Instead of Cost

One of two methods may be used to record the income effect of valuing inventory at NRV. One method, referred to as the COST-OF-GOODS-SOLD METHOD, debits cost of goods sold for the write-down of the inventory to NRV. As a result, the company does not report a loss in the income statement because the cost of goods sold already includes the amount of the loss. The second method, referred to as the LOSS METHOD, debits a loss account for the write-down of the inventory to NRV.

Net Realizable Value

Refers to the net amount that a company expects to realize from the sale of inventory. Specifically, net realizable value is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.

Retail Inventory Method with Markups and Markdowns (Conventional Method)

Retailers use markup and markdown concepts in developing the proper inventory valuation at the end of the accounting period. To obtain the appropriate inventory figures, companies must give proper treatment to markups, markup cancellations, markdowns, and markdown cancellations. Assumption A: Computes a cost ratio after markups (and markup cancellations) but before markdowns. Assumption B: Computes a cost ratio after both markups and markdowns (and cancellations). Ending Inventory at Retail X Cost Ratio = Value of Ending Inventory One approach uses only assumption A (a cost ratio using markups but not markdowns). It approximates the lower-of-average-cost-or-market. We will refer to this approach as the conventional retail inventory method or the lower-of-cost-or-market approach. To understand why this method considers only the markups, not the markdowns, in the cost percentage, you must understand how a retail business operates. A markup normally indicates an increase in the market value of the item. On the other hand, a markdown means a decline in the utility of that item. Therefore, to approximate the lower-of-cost-or-market, we would consider markdowns a current loss and so would not include them in calculating the cost-to-retail ratio. Omitting the markdowns would make the cost-to-retail ratio lower, which leads to an approximate lower-of-cost-or-market.

Lower-of-Cost-or-Market

The FASB decided to grant an exception to the LCNRV approach for companies that use the LIFO or retail inventory methods. Rather than comparing cost to net realizable value, under the alternative approach, companies compare a "designated market value" of the inventory to cost. The approach is commonly referred to as LOWER-OF-COST-OR-MARKET (LCM). This approach begins with replacement cost, then applies two additional limitations to value ending inventory—net realizable value and net realizable value less a normal profit margin. As discussed earlier, net realizable value (NRV) is the estimated selling price in the ordinary course of business, less reasonably predictable costs of completion and disposal (often referred to as net selling price). A normal profit margin is subtracted from that amount to arrive at net realizable value less a normal profit margin. The upper limit (ceiling) is the net realizable value of inventory. The lower limit (floor) is the net realizable value less a normal profit margin. What is the rationale for these two limitations? Establishing these limits for the value of the inventory prevents companies from over- or understating inventory.

Methods of Applying LCNRV

The LCNRV rule may be applied either (A) directly to each item, (B) to the total of the inventory, or in some cases (C) to the total of the components of each major category. All three methods are acceptable, however, method (A) is more common and gives the most conservative (lowest) inventory value.

Valuation at Net Realizable Value

Under limited circumstances, support exists for recording inventory at net realizable value, even if that amount is above cost. GAAP permits this exception to the normal recognition rule under the following conditions: 1. When there is a controlled market with a quoted price applicable to all quantities, 2. When no significant costs of disposal are involved, and 3. The product is available for immediate delivery.

Analysis of Inventories

Using financial ratios helps companies to chart a middle course between these two dangers. Common ratios used in the management and evaluation of inventory levels are inventory turnover and a related measure, average days to sell inventory.

The original cost of an inventory item is above the replacement cost. The inventory item's replacement cost is above the net realizable value. Under the lower of cost or market method, the inventory item should be valued at... a. Net realizable value. b. Original cost. c. Net realizable value LESS normal profit margin. d. Replacement cost.

a. Net realizable value.

Losses on purchase commitments are recorded at the end of the current year when: a. The contractual cost of the inventory in an irrevocable purchase contract exceeds the current cost. b. The purchase contract is irrevocable. c. The buyer purchased a quantity of inventory that was not sufficient to avoid a LIFO liquidation. d. The current cost of the inventory is less than the inventory cost in the purchase contract.

a. The contractual cost of the inventory in an irrevocable purchase contract exceeds the current cost.

Which of the following is not an assumption made when using the gross profit method? a. The cost ratio is computed after markups (and markup cancellations) but before markdowns. b. Goods not sold must be on hand. c. The beginning inventory plus purchases equal total goods to be accounted for. d. Sales, reduced to cost, deducted from the sum of the opening inventory plus purchases equals ending inventory.

a. The cost ratio is computed after markups (and markup cancellations) but before markdowns.

When marking up a specific line of household items for resale, a retailer computes its markup as 40% of cost. For purposes of estimating ending inventory using the gross margin method, what percentage is applied to sales when estimating cost of goods sold? a. 29. b. 71. c. 60. d. 40.

b. 71.

When net realizable value is lower than cost, and the loss method applying the lower-of-cost-and-net-realizable approach of recording the write-down is used, what account is credited? a. Cost of Goods Sold. b. Allowance to Reduce Inventory to Market. c. A loss account. d. Inventory.

b. Allowance to Reduce Inventory to Market.

According to the FASB conceptual framework, which of the following attributes would not be used to measure inventory? a. Net realizable value. b. Present value of future cash flows. c. Historical cost. d. Replacement cost.

b. Present value of future cash flows.

If the foregoing figures are verified and a count of the ending inventory reveals that merchandise actually on hand amounts to $108,000 at retail, the business has... a. realized a windfall gain. b. sustained a loss. c. no gain or loss as there is close coincidence of the inventories. d. none of these answer choices are correct.

b. sustained a loss.

How does the retail inventory method establish the lower-of-cost-or-market valuation for ending inventory? a. By excluding net markups from the cost-to-retail ratio. b. By excluding beginning inventory from the cost-to-retail ratio. c. By excluding net markdowns from the cost-to-retail ratio. d. The procedure is applied on a cost basis at the unit level.

c. By excluding net markdowns from the cost-to-retail ratio.

A firm's inventory was destroyed by fire on August 14 of the current year. Fortunately, the firm had insurance to cover the loss. However, most of the inventory records were also destroyed in the fire. The average gross margin percentage is 40%, beginning inventory was $200,000, and $1,000,000 of purchases had been made through August 13. The firm had recorded sales of $1,200,000 through that date. Estimate the cost of the inventory lost in the fire. a. $720,000. b. $0. c. $280,000. d. $480,000.

d. $480,000.

Medi Corporation, a manufacturer of ethnic foods, contracted in 2016 to purchase 2,000 pounds of a spice mixture at $5.15 per pound, delivery to be made in May of 2017. By December 31, 2016, the price per pound of the spice mixture had risen to $5.65 per pound. In 2016, Medi should recognize... a. a loss of $1,000. b. a gain of $1,000. c. a loss of $10,300. d. no gain or loss.

d. no gain or loss.